Tax Pipeline Strategy
When an individual dies owning shares of a private corporation, a problem of double taxation may occur. The first layer of tax arises from the deemed disposition of the shares at the time of death. A second layer of tax would also apply when the assets of the corporation are liquidated and distributed to the estate/beneficiaries. This distribution would be treated as a dividend for tax purposes. In this way the estate is taxed on the same value twice: first, as capital gains taxes due to the deemed disposition on death, and second, dividend taxes when the corporate assets are distributed to the estate.
A pipeline transaction is a commonly used tax planning strategy to avoid this double taxation issue. The strategy takes advantage of the high cost base created by the deemed disposition on death, allowing the estate to extract corporate surplus on a tax-free basis. In order to offset the professional fees of the pipeline strategy, the amount of cash being removed must be at least a few hundred thousand dollars.
The following are the basic steps of the tax pipeline strategy:
A new company (B Co) is incorporated with a similar share structure to the existing company and obtains a GST account. The GST account must be in place before any restructuring.
If the shares of A Co do not have the required attributes or there are insufficient shares authorized, the share capital of A Co will be restructured under the Business Corporations Act.
The shareholder’s currently issued shares are exchanged for new shares in A Co in order to meet the requirements of the Income Tax Act.
A Co is valued to determine the value of the shares of A Co. This process requires the shareholder to provide their best estimate of the fair market value of each asset that A Co owns. The fair market value is the value that an independent third party would pay for the assets of A Co. Depending on the business that A Co operates, there may be goodwill to be valued as well. The total fair market value of all the assets less the debt is the fair market value of the shares.
The shareholders of A Co sell their shares at fair market value to B Co and in exchange receive a promissory note from B Co. The shareholders report a capital gain on their personal income tax return equal to the fair market value of A Co shares less the cost of A Co shares. 50% of the capital gain is taxable which the shareholders pay personal income tax. In an Estate situation, capital gain is reported on the Final T1 personal tax return of the deceased.
After at least 12-14 months of the incorporation of B Co the two companies are amalgamated.
The promissory note to the shareholders from B Co. is now a shareholder loan of the amalgamated company.
The excess cash is paid out to shareholders via the shareholder loan. The shareholders have turned a dividend into a capital gain which is taxed at significantly lower rates.